‘Matching Regulations’ Affecting Homeowners’ Insurance Claims: Viewpoint

Gary L. Wickert | Claims Journal | April 4, 2019

It remains one of the most difficult issues to deal with in the world of property insurance. Homeowners’ insurance policies usually contain a provision obligating the carrier to repair or replace an insured’s damaged property with “material of like kind and quality” or with “similar material.” They cover property damage resulting from “sudden and accidental” losses. When damage caused by fire, smoke, water, hail, or other causes results in a small portion of a home or building being damaged (e.g.,shingles, siding, carpet, cabinets, etc.), whether and when a carrier must replace non-damaged portions of a building in order for there to be a perfect match remains a point of contention. It is a matter of great importance to insurance companies because “matching” problems with a slightly-damaged section of roof or flooring can lead to a domino effect of tear out and replacement costs of many items that are not damaged. The problem of partial replacement is especially troubling where the damaged siding or shingles have been discontinued, making it virtually impossible to properly match. To replace only the damaged portion would result in an obvious aesthetic deficit due to a clear difference in the appearance of the replaced portion of the building from the portion that remains undamaged.

Would the entire structure need to be re-sided or the entire roof re-shingled? Or is it sufficient to replace just one wall of siding or just a few shingles? Whether or not the insurance company must pay to replace entire sections of the structure in order to bring the property back to its previous uniformity and aesthetics can bring various state insurance laws and regulations into play. On the one hand, many pundits claim that the terms of the insurance policy require the carrier to pay the cost to “repair or replace with similar construction for the same use on the premises.” They argue that “similar” doesn’t mean matching exactly. Others argue that coverage for “matching” and “uniformity” under a homeowner’s policy doesn’t exist without a specific endorsement. The truth lies somewhere in between and can vary greatly from state to state.

Replacement Cost Value (RCV) vs. Actual Cash Value (ACV) Policy

There are two primary valuation methods for establishing the value of insured property for purposes of determining the amount the insurer will pay in the event of loss under a homeowner’s policy:

  • Replacement Cost Value(RCV): This method is usually defined in the policy as the cost to replace the damaged property with materials of like kind and quality, without any deduction for depreciation. It pays an insured for the value of replacing the damaged property without deduction for deterioration, obsolescence, or similar depreciation of the property’s value. The carrier assumes the cost of paying the full cost of repairing or replacing the damaged property.
  • Actual Cash Value(ACV):This method pays an insured for a similar item less depreciation. ACV is ordinarily determined in one of three ways: (1) the cost to repair or replace the damaged property, minus depreciation; (2) the damaged property’s “fair market value” (“FMV”); or (3) using the “broad evidence rule,” which calls for considering all relevant evidence of the value of the damaged property. The insured bears the difference between the depreciated value of the damaged property prior to loss and the higher cost of repairing or replacing it.

The issue of “matching” or “uniformity” in first-party homeowners insurance claims is one that lends itself to RCV policies. If property is only partially damaged, the carrier takes the position that it is only required to pay for repair or replacement of the limited portion of the property that is damaged. The insured argues that replacing only the damaged property restores the functionality of the roof but does not fully replace the damaged property because the replaced property does not match the existing property. For example, a roof had a uniform appearance, and uniformity has a significant effect on value. Therefore, the proper measure of RCV is the cost to replace the entire roof to restore the uniform appearance. This is known as the issue of “matching” or “uniformity.” The issue is whether the carrier has to “match” the damaged property to the undamaged property in order to return it to its previous “uniform” appearance and restore the entire home to its condition prior to loss.

Whether the policy is an RCV or ACV policy can make a big difference. ACV coverage pays an insured for a similar item less depreciation. RCV coverage compensates an insured for the value of replacing the damaged property without deduction for deterioration, obsolescence, or similar depreciation of the property’s value. An insurer with an ACV policy may be able to exercise the option to repair, restore, or replace the damaged property itself rather than having to pay for the cost to repair the property with property of like kind and quality. Moreover, some “matching” regulations only apply to RCV policies.

A good illustration of the matching/uniformity problem is found in a 2014 Minnesota federal district court case in which a manufacturer discontinued the shingles used on the insured’s roof, thus leading to a mismatch problem. The issue was whether the carrier was obligated to replace the damaged shingles with substantially similar shingles or to pay for new shingles for the entire roof. Trout Brook S. Condo. Ass’n v. Harleysville Worcester Ins. Co., 995 F. Supp.2d 1035 (D. Minn. 2014). The Harleysville RCV policy provided coverage which obligated it to pay for the property’s “replacement cost,” defined as:

(1) “the cost of repair or replacement with similar materials for the same use and purpose, on the same site,” or

(2) “the cost to repair, replace, or rebuild the property with material of like kind and quality to the extent practicable.”

Harleysville claimed only partial damage to the roof and allocated $21,000 for roof repairs, but the insured’s construction expert believed the roof had to be entirely replaced at a cost of more than $800,000. In addition, the shingles were no longer being manufactured. The insured sued, arguing that the unavailability of matching shingles entitled it to full roof replacement. The court noted that the “covered property” under the policy was defined as the buildings (rather than the individual items on the property) and held there was a jury question as to whether the building suffered a loss on account of the unavailability of matching roof shingles. Whether Harleysville was able to replace shingles with shingles of a “like kind and quality” hinged on whether the unmatched shingles would provide an acceptable aesthetic result, and that had to be determined by a jury. The idea is that property that has not been physically damaged may become “damaged” where replacement of physically damaged property does not lead to an aesthetic result acceptable to the insured. It suggests that the carrier has an obligation beyond repairing the functionality of the damaged property, by paying to repair the aesthetics of the building.

Notwithstanding any insurance regulations that control the issue, a carrier’s obligation to pay for matching depends on the policy language and hinges on whether the loss payment and valuation terms of the policy can be read to obligate the carrier to match the replacement materials. The industry’s response is that allowing coverage for matching provides a windfall to the insured. To allow for full replacement of matching roofing and siding can be unduly burdensome on a carrier whose policy agrees only to repair damaged portions of the building.

Terms of Insurance Policy

The terms of insurance policies vary greatly and are extremely important to determining the carrier’s obligations in a claim which involves a “matching” concern. The current ISO HO-3 and HO-5 and company-specific policies contain “Loss Settlement” provisions which provide for payment of the “replacement cost of that part of the building damaged with material of like kind and quality and for like use.”

Individual insurance companies may have a variety of other standard terms included in their policies. Some policies may have other terms, conditions, and/or definitions which attempt to address the “matching” or “uniformity” issue and limit exposure in such situations. Some policies even contain “Roof Surfacing Loss Percentage Tables” which address the percentage of a roof the carrier will be obligated to replace as a function of the roof’s age and type of roofing surface material. Overshadowing all of the above are a patchwork of insurance statutes and regulations which attempt to govern claims which have a “matching” or “uniformity” component to them.

In response to a proliferation of “matching” claim issues, many insurers have begun inserting language in their policies that expressly precludes the coverage requirement of matching based upon color, a change in product specifications, or other factors, in an attempt to circumvent this clear precedent. Many states have statutes, insurance bulletins, or case law that directly address matching issues, but many do not.

Insurance Statutes, Regulations, and Case Decisions Governing Matching Claims

In an effort to provide uniformity and predictability in this area, many states have passed insurance statutes, rules, and regulations that govern the handling of matching claims. An Ohio regulation states that when “an interior or exterior loss requires replacement of an item and the replaced item does not match the quality, color, or size of the item suffering the loss, the insurer shall replace as much of the item as to result in a reasonably comparable appearance.” O.A.C. § 3901-1-54(I). In Kentucky, a regulation says that if “a loss requires replacement of items and the replaced items do not reasonably match in quality, color, or size, the insurer shall replace all items in the area so as to conform to a reasonably uniform appearance,” although the courts have not applied the regulation in private litigation. 906 Ky. Admin. Regs. § 12:095 § 9(b). Whether the statute or regulation applies, and whether the insured can bring a private right of action under the applicable statute or regulation, are also significant issues.

The National Association of Insurance Commissioners (NAIC) has drafted a model law called the “Unfair Claims Settlement Practices Act.” It is a consumer-protection law that prevents insureds from predatory and unfair claims settlement behavior on the part of insurance companies. Most states have enacted their own version of this model law, and the specifics of each such law vary from state to state. The NAIC Unfair Property/Casualty Claims Settlement Practices Model Regulation (MDL-902, 1997) has a section which reads as follows:

Section 9. Standards for Prompt, Fair and Equitable Settlements Applicable to Fire and Extended Coverage Type Policies with Replacement Cost Coverage.

  1. When the policy provides for the adjustment and settlement of first party losses based on replacement cost, the following shall apply:

(1) When a loss requires repair or replacement of an item or part, any consequential physical damage incurred in making such repair or replacement not otherwise excluded by the policy shall be included in the loss. The insured shall not have to pay for betterment nor any other cost except for the applicable deductible.

(2) When a covered loss for real property requires the replacement of items and the replacement items do not match in quality, color or size, the insurer shall replace items in the area so as to conform to a reasonably uniform appearance. This applies to interior and exterior losses. The insured shall not bear any cost over the applicable deductible, if any.

On the other hand, subsection (B) governs ACV policies and reads as follows:

  1. B. Actual Cash Value:

(1) When the insurance policy provides for the adjustment and settlement of losses on an actual cash value basis on residential fire and extended coverage, the insurer shall determine actual cash value as follows: replacement cost of property at time of loss less depreciation, if any. Upon the insured’s request, the insurer shall provide a copy of the claim file worksheets detailing any and all deductions for depreciation.

(2) In cases in which the insured’s interest is limited because the property has nominal or no economic value, or a value disproportionate to replacement cost less depreciation, the determination of actual cash value as set forth above is not required. In such cases, the insurer shall provide, upon the insured’s request, a written explanation of the basis for limiting the amount of recovery along with the amount payable under the policy.

While Section A of the above regulation establishes a guideline for the insurance company to follow with regard to the payment of claims involving “matching” or “uniformity” issues, it doesn’t necessarily mean that a carrier in any individual state must adhere to those guidelines or that the regulation works to the advantage of a property owner who has been wronged by a carrier who simply ignores the regulation.

Private Right of Action

Most states have case decisions that state that an individual homeowner/insured does not have a private right of action under a state’s statute or regulations governing unfair claims settlement practices and the handling of a “matching” or “uniformity” issue. As an example, in California, the case of Rattan v. United Services Automobile Association, 101 Cal.Rptr.2d 6 (Cal. App. 2000) involved a home damage by fire. United Services Automobile Association (“USAA”) allegedly breached the terms of policy in adjusting the loss, and the insureds claimed that it violated requirements imposed on carriers under regulations established by the Department of Insurance. The Court of Appeals disagreed, stating:

Even in first party insurance cases, neither the Insurance Code nor regulations adopted under its authority provide a private right of action. (Zephyr Park v. Superior Court(1989) 213 Cal.App.3d 833, 839 [262 Cal.Rptr. 106].) Thus, any particular violation of the regulations does not require a finding of unreasonable conduct. (See California Service Station, etc. Assn. v. American Home Assurance Co.(1998) 62 Cal.App.4th 1166, 1175-1176 [73 Cal.Rptr.2d 182].) Rather, as the trial court stated, at most the regulations, which were in evidence, may be used by a jury to infer a lack of reasonableness on USAA’s part. Because given as instructions the regulations would have suggested to the jury that any violation of the regulations was per se a breach of contract or an act bad faith, rather than only evidence of a breach or bad faith, the trial court was fully warranted in rejecting them.

Simply because a state requires carriers to follow a regulation such as the one above doesn’t mean that an individual homeowner (private citizen) has a “private right of action” under the statute or regulation.

Defenses to First-Party Matching Claims

The arguments most effectively used by carriers in combating matching claims include the following:

  • The property lacked uniformity prior to the covered loss, it would be impossible to “conform” any replacement items to an existing “reasonably uniform appearance” and, therefore, the obligation to match the replacement items under the regulation was not triggered;
  • The lack of a reasonably uniform appearance prior to the covered loss was the result of causes that were excluded under the policy so there was no obligation to replace all the existing items because it would represent an unjust windfall to the insured;
  • Even if a matching regulation or obligation applies to the insured’s loss, the evidence establishes that the repair can be performed such that a reasonably uniform appearance can be maintained;
  • The replacement items can be matched to conform to a reasonably uniform appearance because “reasonably uniform appearance” is analogous to “like kind and quality.” The area that must be replaced to conform to a reasonably uniform appearance is less than the entire property (immediate area, slope section, line of sight); and
  • The regulation is not enforceable because it does not create a private right of action.

Much will depend on the court’s and the parties’ understanding of terms such as “like construction and use” or “reasonably uniform appearance.” The “fine print” terms, conditions, and/or definitions of the policy will factor into the “matching” or “uniformity” issue and could limit exposure in such claims.

Cosmetic Damage

While the “matching” issue involves repairing truly “damaged” or “destroyed” property and the ensuing problems that result when the repaired section of a roof, siding, or cabinetry, for example, does not “match” the remainder of the roof, siding, or cabinetry in appearance. “Cosmetic” damage, on the other hand, is a related subject, but differs in that it involves dents, scratches, or other minor imperfections to property which result from a loss, that do not rise to the level of being truly “damaged.” In other words, it is a qualitative difference. The damage is so minor that it is only “cosmetic” and affects only the appearance of the property in a very minor way. Such cosmetic damage does not cause any punctures, leaks, or loss of functionality of a particular piece of property. An example would be dents in a metal roof resulting from a hail storm.

Insurance policies vary, and some include exclusions for “cosmetic damage” or “appearance damage” to property. While not every home or business policy currently includes these kinds of exclusions, a growing number of major insurers have started including them in their policies. One policy might cover cosmetic damage while another will exclude it, while technically covering direct physical lossfrom hail, even if the homeowner’s insurance policy doesn’t distinguish between cosmetic and other types of damage and such damages are usually covered. However, some homeowner’s insurance companies are introducing endorsements which may exclude cosmetic damages. The two organizations that standardize forms and policies for property/casualty insurers, the American Association of Insurance Services (AAIS) and the Insurance Services Office (ISO), have both filed cosmetic damage endorsements. The endorsement also enables the insurer to exclude one component – such as the roof – separately. These are becoming common with homes that have metal roofs.

In practice, what the insurance company considers cosmetic damage as opposed to functional damage is rarely straightforward. In the example of the dented metal roof, what happens if the dents have subtly affected drainage, runoff, or seals? For example, it is not easy to differentiate cosmetic from functional damage on traditional and architectural shingles. Insurers will argue that a few dings to the surface do not compromise the shingle structure, but the storm-chasing roof sales industry will argue that any localized loss of mineral will expedite the demise of the shingle. Profitability in homeowners’ coverage has become a multi-faceted, politicized, and elusive objective in many states. Regulators, politicians, and consumer advocacy groups with little understanding of how insurance works can present significant obstacles to obtaining appropriate rates for such policies and risks.

Recovery of RCV Matching Claim Payments in Subrogation Actions

Subrogation claims traditionally involve an insurance company stepping into the shoes of an insured and proceeding against the third-party tortfeasor who caused the loss in the first place to recover those claim payments. The subrogated insurance company (subrogee) assumes the same rights against the tortfeasor as the insured possessed — no greater, no less. The tortfeasor can usually employ any defenses against the subrogee that it could have employed against the insured. As a result, the measure of recovery (i.e.,damages) for the subrogee is the same measure of damages as for the insured. This creates some unique and troubling issues when the law dictating third-party damages recoverable in tort are different from the measure of a first-party claim payment under a policy and/or applicable law or regulations. An insurance company that has paid additional damages in order to address “matching” problems in a first-party claim may or may not be able to recover those damages in its subrogation tort action against the tortfeasor/defendant. The law varies from state to state.

If a carrier pays for full replacement cost of a house or a portion of a structure, it might nonetheless be limited to recovering the “market value” or difference in market value before and after a loss, in a subsequent subrogation tort action. Whether a tort defendant is liable to a subrogated carrier for the additional claim payments necessary for the damaged property to match and be uniform after repair depends on the state. Reimbursement under an RCV policy is likely to lead to an economic betterment of the insured because it means that payment will be made to replace old, depreciated property with new property. Therefore, subrogated carriers cannot always count on recovering all of the claim dollars they have paid out. Liability carriers will argue they are only responsible for ACV or repair costs. Some states allow for recovery of the full cost of repairs without a reduction for depreciation or betterment, where the repairs do not materially increase the value of the property over its market value prior to the loss.

You can view a chart that summarizes the regulations or laws in all 50 states regarding the matching issue in the payment of first-party insurance claims HERE. This chart focuses on homeowners’ claims and only tangentially discusses commercial property policies/claims, although if law regarding a commercial policy is all that is available, it is included. It does not address whether damage alleged to be purely “cosmetic”, such as dents to a metal roof caused by hail, is covered “direct physical injury” or the issue of upgrades required by changes in modern zoning or building codes. It also does not address whether an individual private homeowner has a “private right of action” under the law of each state to mandate compliance with these regulations by an insurance company in a first-party RCV property damage claim or if a subrogated insurance carrier can recover the full RCV matching claim payments it has made in a civil subrogation tort action filed against a responsible tortfeasor.

Appellate Court asks Florida Supreme Court: What Kind of Damages Are Repair Costs?

Amandeep S. Kahlon | Bradley Arant Boult Cummings | February 26, 2019

On January 25, 2019, a Florida appellate court certified the following question to the Florida Supreme Court:


The answer to this question is of interest to the construction community because of the prevalence of consequential damage waivers in construction contracts.

In Keystone Airpark Authority v. Pipeline Contractors, Inc., an owner contracted with a general contractor for the construction of an airplane hangar and taxiways in Clay County, Florida. The owner separately contracted with an engineering firm to inspect, observe, and monitor the contractor to ensure compliance with the plans and specifications, including the use of suitable materials by the contractor. After the contractor completed the project, the owner alleged that the hangar’s concrete slabs and the concrete taxiways began to deteriorate prematurely because of the contractor’s use of the substandard stabilization materials underneath the structures. The owner sued the contractor and the engineering firm for the costs to repair and replace the hangar, taxiways, and underlying subgrades.

In response, the engineering firm moved for summary judgment arguing that the incidental, special, and consequential damages waiver in its contract precluded award of the repair and replacement costs sought by the owner. The firm argued that the owner could only recover the costs of the inspection services provided under the inspection contract for any breach. The trial court agreed and enforced the consequential damages waiver, and the owner appealed.

On appeal, the court analyzed whether the damages sustained by owner were general, special, or consequential in nature. The court determined that the repair costs were not special damages because the costs of repair were likely to result from the engineering firm’s failure to fulfill its explicit inspection obligations and did not involve special circumstances for which actual notice may have been required. In other words, the cost to repair and replace the hangar and taxiways was a natural and reasonable consequence of failing to inspect and verify the suitability of the materials used.

However, the appellate court also concluded that the repair costs were not general or direct damages since they did not arise from the immediate transaction between the engineering firm and the owner for provision of inspection services. Per the court, even assuming the engineering firm failed to inspect, the contractor could have completed construction correctly, so the repair costs were not a direct result of the engineering firm’s breach.

The court, instead, analogized the facts in Keystone Airpark to other failure to inspect cases, where Florida courts categorized repair costs as consequential damages, or foreseeable damages that stem from losses incurred by the non-breaching party’s dealings with third parties. But, the court also acknowledged that other failure to inspect cases did not address an express contractual duty to inspect and determine suitability of construction materials, as at issue in Keystone Airpark. Because of this concern, the appellate court, while affirming the trial court’s summary judgment ruling, certified the question recounted above to the Florida Supreme Court for final determination on how to classify repair cost damages arising from a breach of an express inspection requirement.

If the Florida Supreme Court determines that the repair costs should be treated as general or direct damages, that ruling may transform risk allocation under many Florida construction contracts. Where parties, like architects and engineers, have typically relied on consequential damages waivers to limit liability when performing services like inspections or submittal review, the treatment of repair and replacement costs as general damages will seriously undermine the effect of such waivers and create exposure to significant damages awards. Such damages may substantially exceed the actual costs of the services provided.

To prepare for such a contingency, contracting parties should consider other avenues to limit liability. For example, parties with this potential exposure may pursue hard liability caps tied to insurance policy limits or the price of the services provided. Ultimately, it may be that the Florida Supreme Court sides with past precedent and determines repair costs arising from the failure to inspect are consequential damages, but you should be prepared and plan for an alternative result when negotiating contracts in the interim. Of course, further guidance on this issue depends not only on the Florida Supreme Court’s decision, but also the extent to which other states follow the Florida Supreme Court’s lead on this issue. 

Ice Dammed If You Do, Ice Dammed If You Don’t

Michael Duonocore | Property Insurance Coverage Law Blog | February 8, 2019

This time of year, the northeast of the United States starts to feel insufferably cold, followed up by winter storms which can dump anywhere from an inch to three feet of snow at a time. The snow can be a welcomed arrival in winter as it brings snow days, sleigh riding and joy. It can also signal the beginning of a damming experience; ice damming that is.

You see, ice damming is a term for when snow on your roof starts to melt from either heat building up in your attic, the ambient temperature, or the sun. As the snow melts it slides down your roof and towards your gutters. However, the buildup of snow on the roof and in the gutter prevents the water from properly draining. Then as the sun fades and the temperatures drop again, all that water stuck around your gutters freezes, creating an ice dam. Now while an ice dam may look nice with its icicles hanging there glistening in the sun, it is causing a disaster to your roofing system.

As the ice dam phenomenon sits atop your roof, it can lead to roof leaks, ceiling collapses, and frozen and/or burst pipes. However, most notably, it leads to significant damage to your roofing shingles and gutters. As the water and snow melt and refreeze repeatedly, it expands and contracts the roofing shingles and moves your gutters off their original position. This can cause heavy and extensive damage to your home.

So, what do you do when you see ice damming on your roof? Well besides saying “ice dammit” there isn’t much you can do. Trying to chip the ice away will cause your shingles to break or become damaged. If you are lucky, it will get warm enough to melt the ice and snow and drain over and eventually out of your gutters. However, if you are unlucky, you simply must sit there and wait until spring.

If you notice damage either to your roofing system or interior of your home, make sure you contact your insurance agency. If you need further assistance, it is always a good idea to contact a licensed public adjuster to help navigate the insurance claims process.

Developer’s Failure to Plead Amount of Damages in Cross-Complaint Fatal to Direct Action Against Subcontractor’s Insurers Based on Default Judgment

Christopher Kendrick and Valerie A. Moore | Haight Brown and Bonesteel LLP | January 7, 2019

In Yu v. Liberty Surplus Ins. Corp. (No. G054522, filed 12/11/18), a California appeals court held that a developer’s failure to allege the amounts of damages sought in its cross-complaint rendered default judgments against a subcontractor void and, therefore, unenforceable against the subcontractor’s insurers in a direct action under Insurance Code section 11580(b)(2).

Yu, the owner, hired ATMI to develop a hotel. ATMI subcontracted with Fitch to perform stucco and paint work. Yu sued ATMI for construction defects and the developer cross-complained against its subcontractors, including Fitch, for breach of contract; warranty; indemnity, etc. Yu’s operative complaint prayed for damages “in an amount not less than $10,000,000, according to proof.” ATMI’s cross-complaint stated that it incorporated the allegations of Yu’s complaint “for identification and informational purposes only,” but “does not admit the truth of any allegations contained therein.” The cross-complaint also prayed for damages with respect to the various causes of action “in an amount according to proof.”

Fitch defaulted. ATMI then settled with Yu, including an assignment of rights against Fitch. Yu proceeded to prove up a default judgment against Fitch for $1.2 million, which was entered by the court.

Fitch’s insurers moved to vacate the judgment, arguing that ATMI had not stated an amount of damages in the cross-complaint sufficient to support a default judgment. That motion was denied on the ground that the insurers lacked standing to contest the validity of the default judgment. In an unpublished opinion the appeals court affirmed, while telling the insurers that they had an alternative remedy of denying any demand for payment and litigating the issue in a coverage action.

Yu then sued the insurers as a judgment creditor in a direct action under Insurance Code section 11580(b)(2). But the court in that action entered summary judgment for the insurers, ruling that the default judgment was void on its face because of the absence of a money demand in the cross-complaint.

The appeals court agreed. The court first pointed out that under Code of Civil Procedure section 425.10(a) in any complaint or cross-complaint “[i]f the recovery of money or damages is demanded, the amount demanded shall be stated.” The court cited exceptions to the general rule in cases involving personal injury or wrongful death, or when the plaintiff is seeking punitive damages. (Citing Code Civ. Proc., §§ 425.10(b); 425.11.) And in those cases, the plaintiff must still serve a separate written statement of damages (citing Code Civ. Proc., §§ 425.11 (compensatory damages), and 425.115 (punitive damages), before a default judgment may be taken. (Code Civ. Proc., §425.11(c).)

The Yu court explained that it is a matter of due process that the defendant must have notice of the specific relief sought, so that he or she can decide whether to appear and defend. Further, the Legislature has provided that a default judgment cannot exceed the amount demanded, or it is void. (Code Civ. Proc., §§ 580, 585; Greenup v. Rodman (1986) 42 Cal.3d 822, 826.)

There was no question that the developer’s cross-complaint failed to meet the requirements, but the Yu court also held that the allegation incorporating the underlying complaint by reference would not suffice either. The Yu court noted that neither statutes nor court rules establish any formal requirements for incorporation by reference, but common law contract principles require that: “(1) the reference to another document [be] clear and unequivocal; (2) the reference [be] called to the attention of the other party, who consented to that term; and (3) the terms of the incorporated documents [be] known or easily available to the contracting parties.” (Citing Kleveland v. Chicago Title Ins. Co. (2006) 141 Cal.App.4th 761, 765.)

After first pointing out that the alleged incorporation by reference was expressly “for identification and informational purposes only,” the Yu court then found the complaint’s allegation of damages “not less than $10 million” to be inconsistent with the cross-complaint’s allegation of damages “in an amount precisely unknown,” and “subject to proof.” Consequently, the incorporation by reference was not “clear and unequivocal,” nor was the precise amount “adequately called to the attention of the other party.” The Yu court ultimately faulted the developer for having failed to state any amounts in the cross-complaint:

“[W]e agree with the trial court’s assessment that ‘because the cross-complaint filed by ATMI specifically declined to state the amount of damages sought . . . , it seems contradictory to basic notions of due process and fairness to find that cross-defendants [the Fitch Entities] have been put on notice of their potential damages by virtue of an allegation in a complaint filed not against them, but against cross-complainant ATMI.’”

Finally, the Yu court rejected an argument that Fitch had entered a general appearance, saying this went to the issue of service or jurisdiction, but not the amount of damages required for a default judgment. Likewise, the Yu court rejected an argument that Fitch could have readily calculated the damages because it had performed the work, saying that was no substitute for adequate notice or due process.

Property Damage Is Not Necessarily Physical In Calif.

Catherine L. Doyle and Jan A. Larson | Jenner & Block LLP | December 10, 2018

In a recent decision, Thee Sombrero Inc. v. Scottsdale Insurance Company, a California appellate court ruled against insurers seeking to limit coverage for loss of use damages related to an ownership interest in tangible property. The appellate court held that the “loss of use” need not be a loss of all possible uses of the property and recognized that the loss of a particular use was sufficient to constitute the required property damage. In addition, the appellate court authorized the use of economic loss calculations as an appropriate measure of this covered property damage. In so holding, the appellate court challenged the reasoning of other opinions in a sister state and elsewhere in California, and its detailed analyses of the more insurer-friendly holdings may provide persuasive support for policyholders facing similar issues throughout the country. We suggest that policyholders facing similar situations familiarize themselves with this opinion when advocating for coverage for loss of a particular use of tangible property, resulting in economic losses.

A unanimous panel of the Court of Appeals for the Fourth District of California recently issued an opinion construing a commercial general liability policy’s coverage for property damage as extending to economic losses stemming from a loss of use of that property for a particular purpose. In Thee Sombrero Inc. v. Scottsdale Insurance Company, a judgment creditor of the policyholder brought suit against the policyholder’s liability insurer to recover the loss of value that resulted from the revocation of a municipal permit to operate a nightclub. The insurer sought to circumvent coverage by contending that the loss of a permit was merely the loss of an intangible right, and that the plaintiff had only suffered economic damages. The insurer argued the plaintiff’s claims therefore fell outside of the scope of the liability policy’s coverage for property damages. In ruling in favor of coverage, the appellate court undertook a rigorous analysis that refuted the insurer’s arguments and distinguished contrary authority that had taken a more insurer-friendly position.

Thee Sombrero Inc. owned commercial property in Colton, California. Sombrero also possessed a conditional use permit, or CUP, issued by the city, which authorized the operation of a nightclub on the premises. In 2007, Sombrero leased the property to lessees who ran a nightclub under the CUP. Among other conditions, the CUP required city approval of the property’s floorplan and mandated that the approved floorplan could not be modified without further city approval. The city inspected the property in connection with the lease and approved the floorplan, which included a single entrance to the nightclub, equipped with a metal detector.

Crime Enforcement Services was hired to provide security services for the nightclub. Unknown to Sombrero at the time, CES converted a storage area on the property into a “VIP entrance” without a metal detector. On June 4, 2007, a fatal shooting occurred inside the nightclub. Sombrero subsequently learned about the “VIP entrance,” and the owner of CES admitted that the gun used in the shooting had entered the club via this unauthorized second entrance.

As a result of the shooting at the nightclub, the city revoked the CUP. Sombrero negotiated with the city and secured a modified CUP, allowing for use of the property as a banquet hall instead of a nightclub. However, this restricted use as a banquet hall was less lucrative than the prior use as a nightclub.

In 2009, Sombrero sued CES for breach of contract and negligence, alleging that CES did not frisk the shooter and that CES’s failure to screen the shooter led to the shooting, which in turn caused the revocation of the original CUP. The loss of the CUP “lower[ed] the resale and rental value of the [p]roperty” and caused “lost income,” since renting the property as a nightclub had been more profitable than renting it as a banquet hall. Sombrero sought damages against CES for “the reduction in fair market value of the [p]roperty” and “lost income.” The president of Sombrero attested that the difference in value of the property under the original CUP versus the modified CUP was $923,078. In 2012, the court entered a default judgment against CES for the $923,078 of lost value.

CES had a general liability policy issued by Scottsdale Insurance Company, which covered CES’s liability for “property damage” caused by an occurrence. The policy defined “property damage” as either “[p]hysical injury to tangible property, including all resulting loss of use of that property,” or “[l]oss of use of tangible property that is not physically injured.” As a judgment creditor of CES, Sombrero initiated a direct action against Scottsdale in 2015 seeking coverage for the loss of use, expressed as the $923,078 in economic losses, caused by CES.

Scottsdale moved for summary judgment, arguing that the revocation of the original CUP was not a loss of use of tangible property. Rather, according to Scottsdale, the loss of the original CUP was merely the loss of an intangible right to use the property in a particular way. Scottsdale further asserted that property damage, as contemplated by the policy, did not include economic loss. Sombrero responded that it lost the use of tangible property because of the revocation of the original CUP and argued that the economic loss resulting from the loss of use of tangible property did constitute property damage covered by the policy. The trial court agreed with Scottsdale and granted the motion for summary judgment in 2016. In its order, the trial court held, “[l]ost value is economic loss, but economic loss is not lost use of tangible property.”

Sombrero appealed, reiterating its argument that the loss of use of the property resulting from the revocation of the original CUP constituted “loss of use of tangible property that is not physically injured.” The appellate court noted that the interpretation of an insurance policy is a question of law subject to de novo review under settled rules of contract interpretation. Among those well-settled rules of interpreting insurance contracts, the appellate court construes ambiguous language to protect the objectively reasonable expectations of the policyholder.

At the outset of its analysis, the appellate court declared that it “defies common sense to argue” that Sombrero’s loss of its ability to use its property as a nightclub is not, by definition, a loss of use of tangible property. The appellate court then dispatched conflicting authority, including a Washington appellate court decision also involving Scottsdale with “strikingly similar” facts. In Scottsdale Insurance Co. v. Int’l Protective Agency, the dispute centered on the loss of a restaurant’s liquor permit caused by the negligence of Scottsdale’s policyholder, a security company that permitted a minor to enter the restaurant. The opinion in IPA did not persuade the appellate court in Thee Sombrero to abandon its “common-sense position.” In the view of the appellate court, the coverage analysis properly focused on the loss of use of property that results from the loss of an entitlement and not the loss of the intangible entitlement itself. Although a permit or license is not tangible property itself, its loss means the owner of the property can no longer use that property in a particular way. Furthermore, the reasonable expectations of the policyholder would construe “loss of use” to include the loss of any significant use of the property, not merely the total loss of all possible uses. Finally, the appellate court parted ways, in dictum, with the IPA court’s assertion that a right to occupy premises is not a tangible property interest. To the contrary, at least under California law, a lease is considered a conveyance of an estate in real property. Moreover, regardless of the technical legal contours, a policyholder would understand “tangible property” in an insurance policy to include leased real property. In any event, the appellate court determined that Sombrero, as the owner of the property at issue, plainly owned an interest in tangible property.

Having disposed of Scottsdale’s argument that Sombrero had only lost an intangible right to use its property in a particular way, the appellate court went on to address other points of disagreement with the trial court’s ruling. The trial court had granted summary judgment for Scottsdale under the rationale that a “mere economic loss” is not property damage. Generally speaking, strictly economic losses — such as lost profits, loss of an investment, loss of goodwill or loss of an anticipated benefit of a bargain — will not constitute tangible property damage as contemplated by a commercial general liability policy. However, where the intangible economic losses provide a measure of damages to tangible property that is covered by the policy, the policy will provide coverage for those damages. In other words, loss of economic value is an appropriate method of measurement to calculate property damage in the commercial general liability policy context. The diminution of property value is not merely economic loss but damages sustained because of property damage. Therefore, the appellate court articulated that the correct principle is not that economic losses can never constitute property damage; rather, only losses that are exclusively economic and that lack any accompanying physical damage or loss of use of tangible property are not property damage. Under this principle, Sombrero suffered a loss of use of tangible property under the policy. Further, the loss of value was a proper measure of those damages. Sombrero’s use of the diminution of value calculation to measure its damages did not provide an escape hatch for Scottsdale to avoid coverage.

The appellate court also dispensed with other precedent offered by Scottsdale. Referring back to the policy language, “[l]oss of use of tangible property that is not physically injured,” the appellate court distinguished a California Supreme Court case that sided with an insurer on claims based on the loss of an easement, which was not itself tangible property, and resulting in loss in value but no physical damage to the injured party’s property. The appellate court also distinguished a 2007 decision from the Second District appellate court involving a case brought by a lessee against its landlord for the landlord’s failure to maintain the property in the condition in which the landlord had contracted to maintain it, as this amounted to a breach of contract claim over leasehold interests and not the loss of use of tangible property.[4] Although the appellate court in Thee Sombrero again expressed doubt, in dictum, over the expressed proposition in the Golden Eagle opinion that leasehold interests are not tangible property, it relied upon Sombrero’s status as property owner to hold that its claim for diminution of value or its ownership interest constituted a claim for loss of tangible property.

Since the appellate court ruled in favor of Sombrero on grounds that the loss of the original CUP was anchored to the covered loss of use of tangible property and was properly measured by the loss of value economic damages, the court declined to address alternative arguments raised by Sombrero. Questions of whether the loss of the original CUP itself constituted a loss of use of tangible property and whether the construction of the unauthorized VIP entrance constituted physical damage to tangible property (arguably not an “occurrence,” defined as an “accident” by the policy) were thus reserved for another day.

The appellate court’s opinion in Thee Sombrero underscores the benefit to policyholders of express policy language that encompasses the loss of use of tangible property that has not sustained physical damage. We recommend policyholders review their commercial general liability policy provisions, including the definitions, and consider the appellate court’s analysis in Thee Sombrero when evaluating whether their policy may extend to claimed loss of use damages, even where property is not physically damaged. Policyholders may find persuasive support in the methodical examination of the practical, “common sense” connection between the loss of a right to use tangible property and the covered loss of use of such property. The opinion also provides an analytical foundation for the applicability of economic losses as the correct measure of the property damages. The strongest support may be for property owners above lessees in Thee Sombrero, although the appellate court articulated certain reservations that suggest it may be persuaded by future arguments regarding similar loss of use claims made by lessees, as well.